Mexico - Housing Finance Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 7097-ME STAFF APPRAISAL REPORT MEXICO HOUSING FINANCE PROJECT May 6, 1988 Trade, Finance and Industry Division Country Department II Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit - Pesos (Mex$) An exchange rate of US$1 - Mex.$1,500, representing the anticipated average exchange rate for 1987 was used for the project analysis. The average free market rate for 1987 was: US$1 - Hex $1,404. The exchange rate as of May 3, 1988, was: US$1 = Mex.$2,291 FISCAL YEAR January 1 to December 31 ABBREVIATIONS AND ACRONYMS ACF Average Cost of Funds to the Banking System BANOBRAS Banco Nacional de Obras y Servicios Publicos, S.N.C. (National Bank for Works and Public Services) FOVIMI/ISSFAM Social Security Institute of the Armed Forces FONHAPO Fondo de Habitaciones Populares (Low Income Housing Fund) FOVI Fondo de Operacion y Financiamiento Bancario a la Vivienda (Housing Fund for Commercial Banks) FOVISSSTE Housing Fund for State Service Workers GDP Gross Domestic Product GIRA General Interest Rate Agreement GOM Government of Mexico INFONAVIT Fondo Nacional de la Vivienda para los Trabajadores (Housing Fund for Workers) SEDUE Secretaria de Desarrollo Urbano y Ecologia (Ministry of Urban;sm and Ecology)  FOR OMCIUL USE ONLY MEXICO HOUSING FINANCE PROJECT Table of Contents Page No. LOAN AND PROJECT SUMMARY . . . ...................... iii-iv I. SECTORAL CONTEXT.. 1 A. Introduction.. 1 B. Housing Conditions . . 2 C. The Housing Finance System of Mexico.... 3 (a) Introduction .. 3 (b) Institutional Sources of Housing Finance. 4 Role of the Commercial Banks . . 4 Role of the Central Bank . . 6 The Payroll Contribution Funds . . 7 The Public Housing Agencies. . 8 (c) The Mortgage Instrument Used by the Commercial Banks 8 (d) The Impact of Mandatory Housing Finance on Banks .10 D. Experience with Past World Bank Lending ...10 E. Govermnent Strategy ...11 F. Bank Strategy and Rationale for Involvement . . . 12 II. THE PROJECT .................................................... 13 A. Background . . . ............. 13 B. Project Objectives . . ............................ 13 (a) Cost Recovery . . ............... 14 (b) Stabilization of Housing Finance Flows . . 16 (c) Savings Mobilization .. ................................. 16 (d) Lower Income Group Targeting . . . 17 (e) Housing Policy Dialogue . . . 17 C. Project Description . .... 18 D. Project Cost and Financing .... 18 E. Borrowing and Onlending Arrangements .... 19 F. Disbursements . . ............................................. 19 G. Procurement . . ............................................... 20 H. Accounting and A4diting .................................... 20 I. Monitoring and Supervision ..... 20 J. Poverty Aspects . . ........................................... 21 K. Project Benefits . . .......................................... 21 L. Project Risks . . ............................................... 21 This report has been based on the findings of an appraisal mission which visited Mexico in May 1987. The mission comprised Messrs. S. Alber-Glanstaetten (Sr. Operations Officer), U. Pfeiffer and P. Doty. (Cons.). Messrs. H. Jones (LA2TF), B. Renaud (INU) and T. Zearley (LA2IE) contributed to the preparation of the report. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - i -l Page No. III. RECOM MENDATIONS ..... 20 Annexes Annex 1 Public Sector Sources of Housing Finance Annex 2 Central Bank Regulatory Requirements Annex 3 Lending by Commercial Banks for Housing Annex 4 Ratio Analysis of Historical Financial Data of FOVI Annex 5 Detailed Debt Service Schedules and Assumptions for Type A House Annex 6 Detailed Debt Service Schedules and Assumptions for Type B Houses Annex 7 Actual and Projected Commercial Banks Operating Income Related to Mortgage Portfolio Annex 8 Cost Recovery Analysis Annex 9 Si -aas, Content of Housing Policy Statement of February 1987 Annex 10 Government Letter on Housing Sector Policies Annex 11 Disbursement Schedule Annex 12 Documents in the Project File  -Lit MF-XICO HOUSING FINANCE PROJECT LOAN AND PROJECT SUMMARY Borrower: Banco Nacional de Obras y Servicios Publicos, S.N.C. (BANOBRAS) Guarantor: United Mexican States Executing Agency: Banco de Mexico as trustee of Fondo de Operacion y Financimiento Bancario a la Vivienda (FOVI) Amount' US$300.0 million equivalexnt Terms: Repayable over 15 years, including 5 years of grace, with interest at the Bank's standard variable rate. On-lending Terms: The Borrower would on-lend the proceeds of the Bank Loan to FOVI in Pesos at 1.5Z below FOVI's relending rates to the commercial banks. FOVI would relend the funds to the commercial banking system on FOVI's terms and conditions applicable to loans for the lower priced Type A house less a maximum spread of 32. The Guarantor will bear the foreign exchange and interest rate risks. Project Obiectives: The proposed loan would (i) support the achievement of full cost recovery on mandatory lending for housing by the commercial banks, thereby facilitating the resumption of voluntary bank lending and the mobilization of savings for housing finance; (ii) stimulate the introduction of savings schemes for housing, taking advantage of the Rpecial housing-related savinga/investment motivation of households and investors; (iii) increase the supply of affordable housing to the lower income segments of the population; and (iv) widen the sector dialogue to include the role of the public sector, the coordination of public housing finance programs, and rental issues.  - iv - ProJect Description: Financing of construction and individual mortgage loans by commercial banks during 1988 to 1993. Bank funds would be used only for the lower priced house type (Type A), contributing about 19Z of the funds required during the period. The loan would be disbursed only for subloans which extend terms that ensure achievement of full cost recovery as per the March 1988 Central Bank regulations. The project also includes two studies (savings mobilization and rental investments) and a test marketing for a new lower priced housing product. Benefits and Risks: The major benefits are to support implementation of a housing finance system based on full cost recovery regardless of inflation and to help improve resource mobilization. Since Central Bank regulations permitting full cost recovery have been issued, there is no major risk. Estimated Costs: Local Foreign Total Market Prices of Type A Houses 1,276 300 1,576 Percentage Distribution 81 19 100 Financing Plan: Banking System 717 717 FOVI 402 402 IBRD 300 300 Down payments by buyers 157 157 Total 1,276 300 1,576 Estimated Disbursements: Bank Fiscal Year 1989 1990 1991 1992 1993 (US$ millions) Annual 33.0 67.0 67.0 67.0 66.0 Cumulative 33.0 100.0 167.0 234.0 300.0 Economic Rate of Return: Not applicable.  MEXICO HOUSING FINANCE PROJECT I. SECTORAL CONTEXT A. INTRODUCTION 1.01 The population of Mexico is young and has been growing rapidly, particularly in the main cities, exercising strong pressures to expand the housing stock. High levels of inflation during the 1980s have seriously disrupted the housing finance mechanisms that had been put in place in previous decades. The present Mexican administration has given high priority to promoting the housing sector since taking office in 1983. The Government of Mexico (GOM) increased the amount of resources available for housing and bcgan to introduce substantial sector reforms. In parallel, the present Mexican administration has been requesting technical and financial support for housing from the Bank. Bank analysis of the Mexican housing sector in 1984 showed that it was large and fragmented, involving several programs operating under widely divergent conditions. Under the expectation that the Bank would support the sector consolidation and rationalization efforts of the GOM through a series of loans, a first loan of US$150.0 million to an emerging low cost Housing Agency (Fondo de Habitaciones Populares-FONHAPO) was approved in mid-1985 (Loan 2612-ME). FONHAPO was chosen as a starting point for Bank assistance since FONHAPO's programs were consistent with Bank objectives of targeting resources to the poorer segments of the population. As agreed under Loan 2612-ME, a housing finance study (see para. 1.32) was carried out by the Central Bank in 1986 in close consultation with the Bank to serve as the main vehicle for a thorough dialogue on housing finance. 1.02 The main focus of the proposed US$300 million loan is to support improvementt in the housing finance system by achieving full cost recovery under the mandatory commercial bank lending for housing. This key objective had been pursued in the policy dialogue with the GOM since mid- 1986. Finally, Central Bank regulations allowing full cost recovery were issued in March 1988. Full implementation of these regulations will be supported under the proposed loan. The housing finance program involving the commercial banking sector provides considerably larger amounts of finance to the housing sector than FONHAPO. In addition, the quality and conditions of mortgage lending by commercial banks have important implications for the performance of the banking system. Full cost recovery on housing loans sharply reduces housing finance subsidies provided by the commercial banks, and helps stimulate greater resource mobilization for housing and reduce the pressure on interest rates on other commercial bank lending. Full cost recovery on the mandatory lending of the commercial banks for housing virtually eliminates the banks's losses on account of subsidies for mandatory lending. The pursuit of such cost recovery improvements and related subsidy reduction is in accordance with the Bank's interest rate and credit subsidy strategy under the General Interest Rate Agreement (GIRA).  -2- B. HOUSING CONDITIONS 1.03 Housing is an important sector of the Mexican economy. In 1985 new privately and publicly supported investments in housing amounted to US$5.5 billion or 3.12 of GDP which is comparable to other countries at a similar level of development. However, th's level of investment 'has not been sufficient to prevent the housing deficit from reaching an estimated 5 million units or 41? of the existing housing stock of 12.2 million units. Given current production of about 600,000 private and public units per year, as compared with the annual incremental and replacement needs of about 800,000 units, this deficit continues to grow rapidly. Mexico's housing problem is intensified by a high rate of population growth, a rapid pace of urbanization, the spatial polarization of urban growth and demand for housing in the three main metropolitan areas (Mexico City, Guadalajara and Monterrey) and the uneven capacity of the population to finance their housing needs. Concerning the latter, about 70? of households earn less than twice the minimum wage (the likely lowest income household reached under the proposed project) or less than about US$200 per month. 1.04 The predominant form of tenure is ownership, accounting for about 67? of all housing units in 1980, up from 54? in 1960. This trend reflects the reluctance by the private sector to invest in rental properties as a result of a long history of rent control and onerous fiscal measures which have tended to reduce investment yields on housing investments and sharply reduce investors' confidence. Much of the low income rentals in overcrowded quarters takes the form of room rental and doubling up in small units. 1.05 As a result of the 1982 economic crisis in Mexico, there was a sudden and severe drop in housing production, &ud over half of the 1.9 million workers employed in the construction industry were laid off. The construction sector has remained weak ever since, in spite of the reconstruction needs created by the severe earthquake that hit Mexico City in 1985. The present slow economic growth heightens the importance of employment generation as a policy concern and explains, in part, the increasing emphasis placed by the GOM on the housing sector as a potentially important provider of employment and economic growth. 1.06 Past Mexican administrations have been consistently optimistic in preparing public housing plans. Implementation of the 1978-1982 housing plan, covering the Lopez Portillo administration, reached only three quarters of its target of about 740,000 units. The present administration set as its target the construction of 1.6 million units oc more than double the number of the previous administration. The housing plan for 1983-1988 was not only based on plans to channel more resources into the housing sector, but also on providing more lower standard housing to improve affordability, and on improved cost recovery. By the end of 1987 about 1,260,000 units had been constructed. For 1988, the last year of the administration's six year term (sexenio), another 50,000 housing units will be completed. This would bring the total to some 1.3 million. While this would be about 20? short of the 1.6 million target for the sexenio it would still exceed by 75? the total number of units con-itructed under the previous administration. Reflecting the priority given to housing by the  present administration and a drop it privately financed housing, the share of public investment in housing has increased from 1.2Z in 1982 to an estimated 1.5Z in 1988. C. THE HOUSING FINANCE SYSTEM OF MEXICO (a) Introduction 1.07 Traditionally, the private sector has provided the overwhelming share of financing for housing in Mexico. From the mid-70s to the mid-80s an estimated 81X of all housing was financed from private sources. The remaining 191 of housing finance had been provided through a variety of public sector programs (see para. 1.08 and Annex 1). As in other developing countries, most private housing construction in Mexico is carried out in the informal market by homeowners themselves or by unlicensed builders operating at the margin of building codes and without the benefit of access to formal financial markets. The formal financial system has contributed a minor proportion (about 201) of private sector resources. Since 1982, the share of private sector financed construction activities has fallen sharply to an estimated 501 of total housing construction. Falling real wages and increased inflation have substantially decreased the role of the informal market and have caused a contraction of long term lending by financial institutions. Adequate levels of housing finance has become the key constraint of the sector and as indicated in para. 1.06 the public sector has stepped in to compensate temporarily for the lagging private sector initiative. 1.08 Public participation in the financing of housing is characterized by significant fragmentation. Programs are placed under different authorities operating under different rules, including different mortgage instruments. The two most important programs are financed by (i) the commercial banking system under mandatory investment requirements (see para. 1.16) and (ii) the three major payroll contribution funds (see para. 1.23). In 1985 these two main sources provided US$2.4 billion equivalent or 862 of all publicly supported housing finance. The payroll funds are quasi public institutions and are administered by a tri-partite council with representatives of the Government, the employers' associations and the workers' unions. A third public system of housing finance consists of a large number of minor and diverse public housing agencies supported by Federal and State budget transfers such as the local State Housing Tistitutes and the Regional Development Funds. FONHAPO is emerging as the maost important of the housing agencies. 1.09 Public programs support primarily housing construction for first time ownership rather than rental. Public sector housing activities are coordinated by the Ministry of Urban Development and Ecology (Secretaria de Desarrollo Urbano y Ecologia - SEDUE) which has been emporered by the 1983 Federal Housing Law to (i) develop and administer housing policies; (ii) coordinate the housing programs of the public agencies, other than the payroll funds; and (iii) participate in the formulation of investment programs.  -4- (b) Institutional Sources of Housing Finance 1.10 The key features of the three main groups of institutions providing housing finance are highlighted in the summary table belows PRINCIPAL INSTITUTIONS Commercial Payroll Contri- Banks bution Funds FONHAPO Key Fea*4res Lending in 1985 (US$M) 1,190 1,170 110 1985-Market-share (Z) 43 43 4 Principal Source Own Resource Payroll Tax Budgetary of Funds Mobilization Funding Annual Lending Rates ACF I/ 4Z About Inflation Rate Cost Recovery (I) 100 62 2/ 60 3/ Targeting (Minimum Wage Multiples) Up to 12 4/ Up to 5 4/ Up to 2.5 5/ 1/ ACF - Average cost of funds for the commercial banks which represents the weighted average cost of funds of certificates of deposits, bankers' acceptances and promissory notes and represents some 80Z of bank liabilities. It excludes lower cost checking and savings deposits which account for the remaining 20I. 2/ Loan payment is defined in minimum salary equi3.alents including a discount. 3/ Upfront subsidy is about 402. 4/ Income per household. 5/ Head of household income. Role of the Commercial Banks 1.11 The present configuration of the commercial banking system is t}.e result of drastic changes in structure and ownership of the banking sector in recent years. In 1978 some 130 private and mixed ownership banks were operating. In late 1982, the GOM nationalized all commercial banks and began the consolidation of banking institutions and branches. In 1987 the GOM, following up on a promise made in 1983, initiated the process of selling 34Z of its share ownership back to the private sector. 1.12 Mexico's banking system now comprises about 20 multibanks (i.e., general purpose commercial banks), some with nation-wide branch networks. The commercial banking sector is highly concentrated with three banks (Bancomer, Banamex, and Bancaserfin) accounting for about 62Z of the system's total assets of some US$35 billion equivalent at the end of 1986.  -5- The GOM has embarked on a comprehensive review of the Mexican financial sector with a view towards identifying possible areas for improvement. 1.13 The rise of inflation over the last several years to heights unprecedented in Mexico has required the adaptation of lending and deposit instruments to a high inflation environment. Concerned that indexing mechanisms would perpetuate inflation, Mexico has opted to fight inflation at the macro level and to compensate for high and widely fluctuating levels of inflation through high nominal interest rates. Since 1980 both inflation and real interest rates have been fluctuating widely as shown in the table below. As a result, the structure of both assets and liabilities of the banking system has become almost exclusively short term, and long- term loans are virtually non-existent. It is too early to gauge the long term impact on inflation of the Government's December 1987 Economic Pact which has resulted in a sharply declining inflationary trend during the first three months of 1988. Monthly inflation rates have declined from 15.52 in January 1988 to 5.1? in March. At the same time real interest rates rose from -2.0Z to 2.8Z. Calendar Year 1980 1981 1982 1983 1984 1985 1986 1987 ---------------------z2--____________________ (1) Nominal ACF1/ 23.0 33.0 49.0 74.0 65.0 73.0 119.0 144.0 (2) Inflation2/ 30.0 29.0 99.0 81.0 59.0 64.0 106.0 160.0 (3) Real ACF -5.0 3.0 -25.0 -4.0 4.0 5.0 6.0 -6.0 1/ Calculated as the yearly average compounded monthly. 2/ Calculated as the yearly average January to December. 1.14 Rapid changes in the economic environment, especially the levels of inflation and interest rates, contributed heavily to an erratic pattern of resource mobilization and financial intermediation by the commercial banks. Bank resources in real terms grew 161 and 5? in 1981 and 1984 but fell between 11? and 14X annually in 1982, 1983, 1985, and 1986. The commercial banks' ability to mobilize resources has also been affected by the recent growth of a parallel financial system, particularly the private brokerage houses, which are absorbing a large share of corporate financial intermediation. 1.15 Both the liquidity and levels of voluntary lending of the banking system are constrained by reserve and mandatory investments requirements. Only 25Z of the commercial banks' resources can be lent without being subject to either mandatory reserve, lending or interest rate regulations. 1.16 Since the 1960s, regulations of the Central Bank (Banco de Mexico) require commercial banks to ti) lend for housing construction from their own resources a percentage of the banks' liabilities (now 6Z); (ii) follow prescribed terms and conditions for construction and individual mortgage loans (or.ginally for five and now for two types of housing, A and B);  (iii) lending only for housing that meets minimum design standards and limit sale price; and (iv) target households with incomes of up to 12.0 multiples of the minimum wage. Any bank that fails to lend the mandatory amounts, must deposit the equivalent with the Central Bank at a penalty interest rate. 1._7 Up to the March 1988 reform of the Central Bank housing regulations (see para. 1.02) the 62 mandatory lending for housing accounted for most of the subsidized lending the commercial banks were required to make. The revenue losses to the banks which resulted from subsidized lending have been a major cause of distortions in lending rates in that they had to be offset as far as possible by higher rates on the 442 of bank lending for which rates were not regulated (see para. 1.28). Besulting free (unregulated) market interest rates charged by commercial banks were undoubtedly higher than they would have been without this distortion. With interest rates on new housing loans now allowed at ACF, housing credit subsidies provided by the commercial banks will be reduced, and unregulated lending rates can be expected to become lower relative to the commercial banks' costs of funds. This is an important contribution to interest rate and financial sector rationalization. 1.18 The mandatory housing finance system supports primarily new construction although regulations permit also financing of home improvement and urban renewal within the 62 requirement. New housing projects are initiated by mostly private developers who construct and sell houses in the market at their own risk. The construction is typically carried out by the developers or subcontracted. The commercial banks are partners in this process by providing at their risk construction financing and, upon housing completion and sale, by refinancing the construction loan, thus providing mortgages to individual buyers. The construction and selling cycle typically lasts about 16 months. Over the years a core of about 50 developers have specialized in this market. Some 2.5 million people living in about 400,000 units have so far benefitted from this system with projects typically located in the principal urban centers of the country. In recent years beneficiaries have been overwhelmingly young couples with two children or less. Role of the Central Bsank 1.19 In addition to its regulatory role (para. 1.16) the Central Bank provides financial support for housing by extending loans (for terms and conditions see para. 1.22) to its trust fund, the Fondo de Operacion y Financiamiento Bancario a la Vivienda (FOVI) for further onlending to the banks. In 1987 FOVI funded about 13? of the banks' lending for housing. In recent years, the Central Bank's financial support was increased significantly to compensate for the reduced availability of Government budgetary resources and the erratic resource mobilization level experienced by the commercial banks. 1.20 FOVI, which was created in the sixties, is the entity responsible for supervising compliance by commercial banks with the Central Bank's regulations on the mandatory lending requirements for housing. FOVI performs this function by (i) reviewing and approving all project proposals  - 7 - put forward by developers and banks and (ii) monitoring compliance with all other conditions such as loan terms and eligible sales prices for houses. Through its lending operations FOVI influences significantly the regional distribution of housing funds by providing additional resources to supplement the commercial baiks' lending for housing once they have met their 6O mandatory sector lending requirement. FOVI's policy is to (i) direct its resources away from the major metropolitan areas to medium sized cities and (ii) fund primarily the lowest priced house type (Type A) with sales prices ranging at present from US$7,500-10,000 equivalent. FOVI's operations include lending for investor owned rental housing which increased sharply in recent years and represented about 552 of FOVI's loan portfolio as of December 1987. For details on housing financing provided by the banks and FOVI's portfolio in recent years, see Annex 3. 1.21 FOVI is an effective, well regarded and efficient organization with a small staff of about 100 based in its head office in Mexico City. Management and staff are well qualified, remunerated and motivated. Most FOVI staff are involved in the technical review of the developers' housing project proposals, and the monitoring of their execution. In recent years FOVI reviewed annually as many as 450 projects for a total of 180,000 houses. All lending orerations need the final approval of its Board which includes representatives from the Ministries of Planning and Budget, Finance, and Urban Development as well as the Central Bank. 1.22 FOVI's financial structure is simple and its operations have been designed to avoid any credit, interest rate, maturity or foreign exchange risks. As of December 31, 1987, about 9221 of its total assets of Mex$448 billion (US$203 million equivalent) represented loans to the commercial banks and 702 of its financing had been obtained from the Central Bank. Its outstanding debt to the Central Bank amounted to Mex$321 billion (US$146 million). The remainder of FOVI's funding came from federal budgetary contributions and a small amount of retained earnings. FOVI's lending rates are governed by the mandatory rates for homebuyers (see Annex 8, page 7) which allow intermediaries a 2-3Z p.a. margin. FOVI itself retains a spread of 1.52 p.a. designed to cover its administrative costs. FOVI's debt service payments to the Central Bank are fully covered by the repayments it receives from the commercial banks. FOVI's loan portfolio of about 1,000 loans is 1002 current because all payments due from the banks are automatically deducted from their deposits with the Central Bank. For FOVI's full historical financial statements, see Annex 4. The Payroll Contribution Funds 1.23 Three separate payroll contribution funds for wage workers in the private (INFONAVIT) and public sectors (FOVISSSTE)2 and the military (FOVIMI/ISSFAM)3 constitute the second major system providing housing 1/The rest were financial investments. 2/Housing Fund for State Service Workers. 3/Social Security Institute for the Armed Forces.  - 8 - finance. These funds are financed primarily by compulsory contributions paid by the employers equivalent to 5? of their wage bill. The funds primarily support new housing units, targeting exclusively contributors earning less than 5 minimum wages. The contracting and supervision of housing projects is typically carried out by the funds themselves. The dominant housing fund is the Fondo Nacional de la Vivienda para los Trabajadores (INFONAVIT) which receives contributions from about 5.2 million accredited workers and has made some 615,000 housing loans since its inception in 1972. Because of a highly subsidized 4Z fixed interest rate on its loans, until recently cost recovery had been extremely low (about 14? under an assumed 1002 average inflation rate during the life of these long term loans). However, as this low cost recovery had become clearly unsustainable, a new system of INFONAVIT mortgage loan terms was implemented in 1987, essentially linking loan repayments to a predetermined number of multiples of the minimum wage. Cost recovery thus rose to about 62Z. The Government intention to introduce similar changes in the other major payroll contribution fund, FOVISSSTE, during 1988 are laid out in the Housing Policies letter (para. 2.09). The Public Housing Agencies 1.24 The third and by far the smallest housing finance system consists of a large number of relatively small housing agencies at the federal and local levels funded by budgetary contributions or managed autonomously as part of larger programs providing housing for the employees of the petroleum and electricity corporations. The most important agency is FONHAPO, which is a trust fund of Banco Nacional de Obras y Servicios Publicos, S.N.C. (BANOBRAS), the National Bank for Works and Public Services. FONHAPO operations have been expanding rapidly in recent years, inter alia assisted by Bank financing under Loan 2612-ME. FONHAPO deals with the largest and poorest segment of the market and channels credits through intermediary federal and local public institutions; it has no direct contractual relationship with the ultimate beneficiaries of its lines of credit. FONHAPO loans which are made to non-wage earning heads of household earning less than 2.5 times the minimum wage, reach a low income segment of the population. FONHAPO emphasizes shelter solutions in the form of sites and services projects and housing built by progressive construction methods. (c) Mortgage Instrument Used by the Commercial Banks 1.25 As long as inflation and interest rates are low, fixed rate mortgages (FRM) are the preferred lending instrument for housing. In Mexico a FRM system operated during many years with relatively modest subsidies. For example, during 1968 to 1972 interest rates on housing of about 62 were slightly positive in real terms on average (inflation hovered around 5Z) although market interest rates were somewhat higher. This traditional financial environment changed completely when rapidly rising higher inflation early in the 1980's caused the ACF to climb sharply and eventually to reach a level of 74? p.a. in 1983. Despite these historically high inflation and nominal interest levels, rates on the  - 9 - commercial banks' mandatory housing loans remained fixed and did not exceed 14? in 1983. This lag in adjusting the mortgage lending rates can be explained, in part, by the country's inexperience in dealing with high levels of inflation and the widely held expectation that inflation would be brought down rapidly. The contrast of the fixed low rates and the persistently much higher market rates provided huge uncontrolled subsidies to housing loan recipients and caused substantial decapitalization to the banking system. This problem could not be solved by merely raising the fixed interest rates, as high interest rates cause loan repayments to accelerate in real terms, raising sharply debt service payments during the early years and making housing finance unaffordable. 1.26 To overcome the problems of unaffordable loan repayments and uncontrolled housing finance subsidies provided by FRM under conditions of high inflation, the Mexican authorities introduced a new system of variable mortgage loans in 1984 that is (1) based on ACF as the market reference rate and (ii) designed to remain affordable. This new loan instrument allocates obligations and risks between lenders and borrowers more rationally because it recognized each party's constraints. On the one hand, households must be able to make loan payments out of their cash flow. To ensure affordability, the new variable mortgage system therefore provides that the borrower's monthly loan payment is initially set in line with household income and is subsequently adjusted in direct proportion to changes in the minimum wage. On the other hand, if housing lending is to become financially viable, commercial banks must be able to recover their costs. Therefore, any interest not covered by the monthly loan payments is added to the unpaid loan balance. Under this system, interest financing does not increase the outstanding loan balance in real terms and the achievement of full cost recovery is entirely consistent with affordability. 1.27 After further adjustments in 1986, 1987 and finally in March 1988, the mortgage instrument has the following features: (a) the basic obligation of the Borrower is the initial monthly loan payment set as a percentage of the loan; (b) the monthly loan payment is adjusted by the percentage increase in the minimum wage; (c) interest rates are set at ACF; (d) if the monthly loan payment does not cover all interest due, such interest can be added to the loan amount; and (e) the loan maturity is flexible but cannot exceed 20 years. (In the unlikely event that an outstanding balance exists after 20 years, the banks would have to write off the loss - see para. 2.03). The most recent adjustments in the mortgage instrument are fully in line with the central objectives of the proposed loan, i.e., to support the achievement of full cost recovery in housing finance provided by the commercial banks. A detailed evaluation of the current mortgage system is provided in paras. 2.03 and 2.04. Supporting month-by-month mathematical calculations illustrating the special features of this type of mortgage are provided in Annex 5 and 6.  - 10 - (d) The Impact of Mandatory Housing Finance on Banks 1.28 The commercial banks' profitability had been seriously affected by low mandatory interest rates on housing loans. Ever since the variable mortgage system was put in place in 1984, interest rates tended to remain well below ACF. In addition, mandatory lending volumes for housing were raised from the equivalent of 3Z to 6Z of commercial banks' total resources. As a result, the commercial banks experienced very substantial foregone revenues4 ranging from US$365 million to US$669 million per year during 1984 to 1986. In 1985 such foregone revenues were equivalent to 722 of their combined pretax income. Due to competition, commercial banks could only compensate an estimated one third of these revenue losses by raising interest and other charges in their other lending operations. On account of the 1987 adjustments in loan conditions (see Annex 8, page 7), banks have been able to reduce their foregone revenues on the mandatory housing loan portfolio substantially, to an estimated US$215 million in 1987. Further substantial reductions are expected on account of the March 1988 adjustments. 1.29 Operationally, the banks' mandatory housing portfolio is performing very well. Overdue loans have remained in recent years at only about 12 of total outstanding loan amounts. Given the current high inflation rates investment in housing has become an important inflation hedge for homeowners and foreclosures occur very infrequently. 1.30 The erratic levels of resource mobilization by the commercial banking system in recent years, coupled with the uncertain inflation outlook, has made it difficult for banks to plan and execute their housing finance commitments which, once begun, are difficult to interrupt as completion of construction needs to proceed speedily. Planning of construction and mortgage lending has to be as precise as possible for two reasons: (i) if banks are too cautious in projecting available resources, they run the risk of not fulfilling the mandatory requirements and thus of suffering interest rate penalties; and (ii) if they are too optimistic by over-estimating the growth of their resources, they are at risk of over- investing in housing and thereby of increasing foregone revenues, beyond the level determined by the housing investment requirements. D. EXPERIENCE WITH PAST WORLD BANK LENDING 1.31 World Bank lending specifically directed to the housing sector began in 1985 with Loan 2612-ME designed to increase public housing investment for the poorest and largest segment of the housing market and to strengthen FONHAPO during a critical expansion phase. Experience under Loan 2612-ME has been good. FONHAPO has efficiently managed a rapidly growing loan portfolio while ensuring allocation of its lending to low- income families. The FONHAPO program enjoys popular recognition and the strong support of central and local governments as reflected by 4/Measured by the difference between ACF and the actual yield on housing loans.  - 11 - satisfactory project execution and a large pipeline of subloan requests. FONHAPO has also substantially revised its mortgage lending instrument to ensure the achievement of the covenanted 50Z level of cost recovery regardless of the level of inflation. FONHAPO's lending terms now provide for Mi) the level of mortgage payments to be maintained in a fixed proportion of the income of beneficiaries (expressed in multiples of the minimum wage); (ii) interest rates equal to the annualized percentage adjustment in the minimum wage; and (iii) an explicit fiscal subsidy in the form of an up-front grant. 1.32 An important component of Loan 2612-ME was the housing finance study which was carried out by Banco de Mexico during 1986 and provides an analysis of the entire housing finance system and the performance of its various components. The execution of the study which achieved a high professional standard was closely monitored by Bank staff. The study focussed on a review of housing finance through the commercial banks, the payroll funds, FONHAPO and the informal sector. The study's analysis and findings contributed to the 1986, 1987 and 1988 changes in the lending terms of the mandatory system of housing finance through the commercial banks to increase cost recovery. The analysis of the mortgage system influenced the design of the new financing instruments implemented by FONHAPO and those now being considered by the payroll funds. These new instruments have had a significant impact on improving cost recovery. Finally, the study provided an important input to the Government's formulation of the Housing Policy Statement issued in February 1987 (see Annex 9). 1.33 The Bank is also assisting the Mexican housing sector through Loan 2665-ME (US$400 million Earthquake Rehabilitation and Reconstruction Loan, approved March 1986) which contains a US$263.8 million housing component that is being executed by FOVI (US$50 million) and FONHAPO (US$132 million and US$81.8 million reallocated from Loan 1990-ME). Both 'OVI and FONHAPO have demonstrated their capacity to execute satisfactorily their respective parts of the project. This loan was formulated in response to a natural disaster; it was thus not considered to be a suitable vehicle to institute any policy reforms in the housing sector. Nevertheless, the loan has had a significant impact by helping to (i) develop improved urban designs for low-income housing in a dense urban context; (ii) maximize the utilization of existing urban infrastructure; (iii) introduce seismic-resistant structural design for low-income housing; and (iv) regularize land tenure in areas that had been under rent control for decades. These important contributions may be replicated in future housing operations in Mexico. E. GOVERNMENT STRATEGY 1.34 Starting in 1983, GOM began reforming public housing policies to reach a larger segment of the needy population by: (i) lowering minimum housing standards; (ii) allocating more resources to, and improving cost recovery on, housing finance; and (iii) creating and promoting FONHAPO with the specific mandate to finance construction of non-conventional housing types for low-income households. In order to demonstrate the GOM's high social priority of facilitating access to housing for all Mexican families,  - 12 - the right to housing was incorporated in the Mexican Constitution in 1983. The same year, a Federal Housing Law was passed, clarifying the GOM strategic role in the sector. GOM continued to introduce system improvements principally related to institutional strengthen4ng and cost recovery. In its Housing Policy Statement of February 1987 (for details see Annex 9) the GOM reformulated and published its housing policies, setting out principally a strategy of (i) further improving cost recovery on housing finance, (ii) promoting savings from households and institutions, (iii) providing incentives to investors for rental solutions, and (iv) simplifying administrative procedures. The statement covers the main areas of housing policy; certain policy improvements and clarifications on future policy directions will be sought in the context of the proposed loan (para. 2.09). F. BANK STRATEGY AND RATIONALE FOR INVOLVEMENT 1.35 The overall strategy of the Bank in the sector is to support, through a series of lending operations, the GOM's policies and reforms aimed at expanding the efficient supply of low and middle income housing through improvements in cost recovery and further streamlining of regulations. The key objective of the proposed project is to support the full cost recovery for mandatory commercial bank lending for housing, even under conditions of high inflation. Full cost recovery is seen as a key step toward the ultimate objective of allowing banks to earn a sufficient return on housing loans. thereby (i) providing an incentive to resume voluntary lending for housing and (ii) facilitating mobilization of savings. The preparation of the project has provided a good opportunity for widening and deepening the Bank's dialogue with GOM on housing and housing finance. A fo'llow-up operation to the first FONHAPO project is being contemplated which would aim at (i) improving the entity's cost recovery, thereby further lowering fiscal subsidies, and (ii) reaching beneficiaries further down the income scale by lowering housing construction costa. Another important area to be addressed relates to the revision of housing codes, at the State and Municipal levels, to ensure a better consideration of seismic risks (studies to provide the adequate technical groundwork have been carried out under Loan 2665-ME) and to support the use of lower construction standards, where technically feasible. Sector work to be initiated this year would examine the planning methodologies used at the Municipal level and the respective standards for providing housing infrastructure (i.e. roads, lighting, water, sewerage, etc.) as well as costs and financing mechanisms. These are promising areas for important policy improvements. 1.36 Continued Bank support, through the provision of financial resources, technical analyses and policy support would be critical to further progress in and deepening of housing sector reforms. The objectives of the proposed project correspond closely to the Government's and the Bank's overall country and sector strategies. Reducing credit subsidies is consistent with the goals of the General Interest Rate Agreement (GIRA) which is governing lending rates for agricultural, industrial, mining and urban infrastructure lending.  - 13 - II. THE PROJECT A. BACKGROUND 2.01 The proposed project was identified in May 1986 and appraised in May 1987. Follow-up discussions with the Mexican authorities have taken place since then focussing mostly on the cost recovery issue. Negotiations took place in Washington during April 25-29, 1988 with the Mexican team headed by Mr. G. Sandoval of BANOBRAS. B. PROJECT OBJECTIVES 2.02 In addition to expanding the supply of finance for lower income housing, the project would have the following objectives: (a) Full Cost Recovery: support the implementation of mortgage design reforms aimed at achieving full cost recovery for housing currently provided through the mandatory lending programs of the commercial banks; (b) Stabilization of Housing Finance Flows: Bank funding would complement the erratic flow of funds for housing finance provided by the commercial banks; (c) Savings Mobilization: review the policies and incentives required to attract more household and institutional savings for housing and facilitate implementation of appropriate action; (d) Targeting: direct Bank resources for lending by the commercial banking system to benefit borrowers qualifying for the existing lower priced house type (Type A), and test-market housing products at 202 lower bales prices. If successful, the provision of lower priced housing would allow the banking system to reach beneficiaries further down the income distribution scale; and (e) Policy Dialogue: widen and supplement the housing policy dialogue in the areas of housing program coordination and housing financeharmonization, savings mobilization and cost recovery in line with the GOM's intentions expressed in its 1987 Housing Policy Statement and letter on Housing Sector Policies letter (Annex 10). The following sections describe how these objectives would be addressed under the proposed loan. (a) Cost Recovery 2.03 The mortgage instrument introduced in 1984 (para. 1.26) represents an imaginative solution for making housing loans both affordable and fully recoverable in real terms5 even under high inflation rates. Prior to its introduction, there was, however, considerable opposition to implementing the new mortgage loan system for three reasons: i) starting interest rates, a politically highly sensitive and visible issue, were considered to be high (15-35Z p.a.); (ii) commercial banks were concerned that interest capitalization would cause the nominal amount of the outstanding loans to 5/Full cost recovery is achieved when the present value of all loan payments equals the loan amount. The discount rate is the inflation  - 14 - get out of control; and (iii) borrowers feared that minimum wage changes would cause the share of their income dedicated to loan payments to rise too rapidly. These concerns were addressed initially by several negotiated compromises. First, starting interest rates were set well below going ACF rates and gradually adjusted to the ACF level in line with the minimum wage increases. Second, the amount of interest which could be financed through capitalization (the interest capitalization limit) was limited to 70Z of the original loan amount. Third, monthly loan payments were to be adjusted only to 702 of minimum wage changes. When it became clear that (i) inflation in Mexico was not falling as had been generally anticipated, but was steadily increasing, and (ii) market participants were increasingly accepting the new system, the Government moved ahead with revisions of the loan conditions (see page 7 of Annex 8) in order to improve cost recovery. In line with this objective, (i) initial interest rates were increased from a 15-352 range to 30-60Z p.a. in 1986; (ii) initial interest rates were directly linked to and set at, 70-100Z of ACF in 1987; (iii) interest rates were finally set equal to ACF in 1988 for all types of housing; (iv) the adjustment on monthly loan payments was increased from 702 of the change in the minimum wage to 10O2 of such change in 1986; and (iv) the interest capitalization limit was increased from 70Z of the initial loan amount to 2002 in 1986 and to 500Z in 1987, and it was lifted entirely in 1988. 2.04 In terms of anticipated cost recovery the progressive system reforms yielded the following results: 1984 1986 1987 1988 Weighted Average Cost Recovery (2) 47 74 90 100 These dramatic and courageous changes and the ultimate goal of 10O2 cost recovery were in line with the findings of the Housing Finance Study (para. 1.32) and the dialogue with the Bank carried out since 1986 in the context of project preparation work. With the 1988 reform, loans would have maturities of about 6 to 9 years assuming ACF parallels inflation in the long term (equivalent to a zero real rate). The 20-year limit would only be reached if minimum wage adjustments lag 1OZ behind inflation and if ACF yields a continuous 4Z real rate. Such long term circumstances of real rates and mia,mum wage lags are considered very unlikely, thereby allowing the conclusion that the mortgage instrument is robust. For a full sensitivity analysis see section A of Annex 8. In comparison, the FONHAPO system which serves the lowest income group, achieves a cost recovery of about 602. 2.05 The 1988 reform, aimed at achieving full cost recovery, is embodied in the Central Bank telex circular 28/88 of March 15, 1988. This Central Bank regulatory provision needs to be accompanied by a reform in each of the 32 states of the Mexican Federation to allow the establishment of mortgage liens in the respective states taking into account unlimited capitalization of interest. In three states such reforms have been put in place, in some 15 states steps towards implementation are at an advanced stage, and in the other states steps of a legal or administrative nature are being taken. To provide states with an additional incentive to proceed speedily with these ancillary reforms it was agreed during negotiations that the proposed Bank loan, in its entirety, would only be disbursed for housing loans to eligible beneficiaries which incorporate loan terms designed to achieve full cost recovery.  - 15 - (b) Stabilization of Housing Finance Flows 2.06 Increases in interest capitalization allow banks to meet the 6X mandatory requirement just by letting loan bilances rise by capitalization of such unpaid interest thereby effectively reducing the provision of fresh funds for new housing. This phenomenon combined with the erratic resource mobilization of the commercial banks, causes housing lending by banks to be subject to sharp fluctuations. By providing additional resources to FOVI for housing lending, the proposed Bank loan would add stability to the financial flows to the sector. (c) Savings Mobilization 2.07 It is part of the Government's policy to stimulate savings of households and institutions in general both for housing finance and other purposes. Up to now the commercial banks were not exploiting the motivation to save on the part of potential house buyers because of the revenue losses on mandated mortgage lending and the high costs of managing a large number of small savings accounts. Institutional savers (investors) are also not tapped, although mortgage backed securities are normally attractive long term financial instruments. The Government plans to support the work of a task force of the Mexican Association of Banks to study the existing disincentives to savings and to identify saving schemes which build upon the special motivation of households to save for housing, including the expectation of obtaining a mortgage loan. It will also review the potential attractiveness to institutional investors of purchasing appropriate mortgage backed securities. It is important to recognize that the achievement of full cost recovery will make it viable for commercial banks to mobilize savings, starting with buyers of the more expensive house type. During negotiations it was confirmed that (i) the Government would cause the savings mobilization study to be carried out and completed by March 31, 1989, with the assistance of the Mexican Association of Banks and based on terms of reference satisfactory to the Bank; and (ii) the study's findings would be discussed with the Bank by June 30, 1989, with the objective of arriving at an appropriate action plan. (d) Lower Income Group Targeting 2.08 The mandatory housing programs of the banking system provide developers and commercial banks with incentives for efficient management, as their own capital is at risk. However, with the exception of FONHAPO, public programs are designed for beneficiaries of the five highest deciles of the income distribution, leaving to the informal market the task of catering to the lower income segment of the population. To encourage the banking system to reach income segments of the population presently closer to the poverty line (two minimum wages), new housing products would be test marketed under the proposed project with selling prices 202 below market prices of the cheaper housing type category (Type A). Selling prices are thus expected to range from US$6,000 to US$8,000 equivalent. Preliminary  - 16 - indications are that developers believe that lot and living areas can be downsized and still be acceptable to potential buyers and as collateral to banks. During negotiations it was confirmed that a test marketing program involving about 2,500 houses will be completed by March 31, 1989 and that its results will be reviewed jointly with the Bank no later than June 30, 1989. Should the experience be positive (taking into account any overlaps with the FONHAPO programs), the program would be expected to be extended. (e) Housing Policy Dialogue 2.09 Loan 2612-ME which was made in 1985 to BANOBRAS acting as trustee for FONHAPO, provided a first opportunity to exchange views on broader housing issues, especially during the execution of the housing finance study. The February 1987 Housing Policy Statement expresses the GOM's basic housing policy direction (Annex 9) which the Bank can support. However, several broader aspects of public sector involvement and coordination of public programs need greater specificity. The GOM is aware that public sector support to housing programs has assumed a relatively much more important role in recent years because of the reduction in private resources available to households and resources supplied by commercial financial institutions. The GOM intends to promote a better balance between the commercial and public sectors in this regard. The GOM will also study incentives for private investors to increase the availability of rental housing, keeping in mind its current limited attractiveness to the landlords. Finally, the GOM plans to monitor closely the large number and varying terms of public housing programs with a view to eliminating any unnecessary overlapping and to assure the consistency of mortgage loan terms and subsidies. The broader aspects of housing policy such as the role of the public sector, the coordination of public sector programs including payroll fund cost recovery issues, cost recovery objectives and limitations on the increase in subsidies, savings mobilization intentions and increased promotion of investor owned rental properties, was covered more specifically in GOM's Housing Sector Policies letter (see Annex 10) agreed during negotiations. During negotiations it was agreed that (i) adoption of cost recovery policies contrary to the letter would constitute an event for suspension of disbursements; (ii) a study on the rental market and the incentives to investors to make investment in such properties sufficiently attractive would be completed by December 31, 1989, and (iii) the study's findings would be discussed between GOM and the Bank by March 31, 1990 and appropriate actions be adopted thereafter. C. PROJECT DESCRIPTION 2.10 The proposed US$300 million loan would finance a time slice of the 1988-1993 lending of the commercial banks targeted at households with incomes of up to 4.0 minimum wage multiples (Type A housing). To facilitate the test marketing of a new lower price house the proposed loan would provide financing for such a test. Project beneficiaries would generally be above the poverty line (above two minimum wages). If the test marketing of new housing products is successful, beneficiaries closer to the poverty line would be reached. It is estimated that about 300,000 Type A houses would be constructed during this period, with 192 of the program's financing provided under the proposed loan. Included in the  - 17 - project are also studies related to savings mobilization and investment in rental properties. D. PROJECT COSTS AND FINANCING 2.11 The estimated investment costs for all the Type A houses expected to be built over the period 1988-93 are shown below: Projected Total 1988 1989 1990 1991 1992 1993 1988-1993 ------------------